Financial Management

Assignment on Factors Determining

Optimal Capital Structure

ITM Business School, Kharghar

Submitted To: Submitted

By:

Prof. Bharat Shah

Arindam Mitra

KHR2009PGDMF002
 Batch – A

Factors Determining Optimal Capital Structure

Introduction

The capital structure of a company has to be planned initially when it is

promoted. The initial capital structure should be designed very carefully. The
management of the company should set a target capital structure and the
subsequent financing decisions should be made with a view to achieve the
target capital structure. The financial manager has also to deal with an
existing capital structure. The company needs funds to finance its activities
continuously. Every time when the funds have to be procured, the financial
manager weighs pros and cons of various sources of finance and selects the
most advantageous sources keeping in view the target capital structure.
Thus the capital structure decision is a continuous one and has to be taken
whenever a firm needs additional finances.

Generally the following factors should be considered whenever a capital

structure decision has to be taken-

1. Assets

The forms of assets held by a company are important determinants of

its capital structure. Tangible fixed assets serve as collateral to debt.
In the event of financial distress, the lenders can access these assets
and liquidate them to realize funds lent by them. Companies with
higher tangible fixed assets will have less expected costs of financial
distress and hence, higher debt ratios. On the other hand, companies,
whose primary assets are intangible assets will not have much to offer
by way of collateral and will have higher costs of financial distress.

2. Growth opportunities

The nature of growth opportunities has an important influence on a

firm’s financial leverage. Firms with high market to book value ratios
have high growth opportunities. A substantial part of the value for
these companies comes from organizational or intangible assets.
These firms have a lot of investment opportunities. There is also higher
threat of bankruptcy and high costs of financial distress associated
with high growth firms once they start facing financial problems. These
firms employ lower debt ratios to avoid the problem of under-
 investment and costs of financial distress. High growth firms would
prefer to take debts with lower maturities to keep interest rates down
and to retain the financial flexibility since their performance can
change unexpectedly any time. They would also prefer unsecured debt
to have operating flexibility. Mature firms with low market to book
value ratio and limited growth opportunities face the risk of managers
spending free cash flow either in unprofitable maturing business or
diversifying into risky businesses. Both these decisions are
undesirable. This behavior of managers can be controlled by high
leverage that makes them more careful in utilizing surplus cash.

3. Trading on equity

The use of fixed cost sources of finance, such as debt and preference
share capital to finance the assets of the company is known as
financial leverage or trading on equity. The word “equity” denotes the
ownership of the company. If the assets financed with the use of debt
yield a return greater than the cost of debt, the earnings per share
increase without an increase in the owner’s investment. The earnings
per share also increase when the preference share capital is used to
acquire assets. But the leverage impact is more pronounced in case of
debt because (a) the cost of debt is usually lower than the cost of
preference share capital and (b) the interest paid on debt tax
deductible. Because of its effect on earnings per share, financial
leverage is one of the important considerations in planning the capital
structure of a company. The companies with high level of earnings
before interest and taxes (EBIT) can make profitable use of the high
degree of leverage to increase return on the shareholder’s equity.

The EBIT-EPS analysis is one important tool in the hands of the

financial manager to get an insight into the firm’s capital structure
management. He can consider the possible fluctuations in EBIT and
examine their impact on EPS under different financial plans. If the
probability of earning a rate of return on the firm’s assets less than the
cost of debt is insignificant, a large amount of debt can be used by the
firm in its capital structure to increase the earnings per share. This
may have a favorable effect on the market value per share. On the
other hand, if the probability of earning the rate of return on the firm’s
assets less than the cost of debt is very high, the firm should refrain
from employing debt capital. It may thus be concluded that the greater
the level of EBIT and lower the profitability of downward fluctuation,
the more beneficial it is to employ debt in capital structure.

4. Debt and Non-debt Tax shields

 Debt reduces tax liability due to interest deductibility and increases
the firm’s after-tax free cash flows. In the absence of personal taxes,
the interest tax shields increase the value of the firm. Generally,
investors pay taxes on interest income but not on equity income.
Hence, personal taxes reduce the tax advantage of debt over equity.
The tax advantage of debt implies that firms will employ more debt to
reduce tax liabilities and increase value. Firms also have non-debt tax
shields available to them. However, there is a link between the non-
debt tax shields and the debt tax shields since companies with higher
depreciation would tend to have higher fixed assets, which serve as
collateral against debt.

5. Financial flexibility

It is prudent to maintain financial flexibility that enables the firm to

adjust to any change in the future events or forecasting error.
Financial flexibility means a company’s ability to adapt its capital
structure to the needs of the changing conditions. The company should
be able to raise funds, without undue delay and cost, whenever
needed, to finance the profitable investments. It should also be in a
position to redeem its debt whenever warranted by the future
conditions. The financial plan of the company should be flexible
enough to change the composition of the capital structure as
warranted by the company’s operating strategy and needs. It should
also be able to substitute one form of financing for another to
economize the use of funds. Flexibility depends on loan covenants,
option to early retirement of loans and the financial slack, viz., excess
resources at the command of the firm.

6. Loan covenants

Restrictive covenants are commonly included in the long-term loan

agreements and debentures. These restrictions curtail the company’s
freedom in dealing with the financial matters and put it in an inflexible
position. Covenants in loan agreement may include restrictions to
distribute cash dividends, to incur capital expenditure, to raise
additional external finances or to maintain working capital at a
particular level. The types of covenants restricting the firm’s
investment, financing and dividend policies vary depending on the
source of debt. While private debt contains both affirmative and
negative covenants, public debt has a lot of negative covenants and
 commercial paper does not entail much restrictions. Growth firms
prefer to take private rather than public debt since it is much easier to
negotiate terms in time of crisis with few private lenders than several
debenture-holders. A highly levered firm is subject to many constraints
under debt covenants that restrict its choice of decisions, policies and
programmes. Violation of covenants can have serious adverse
consequences. The firm’s ability to respond quickly to changing
conditions also reduces.

7. Sustainability and Feasibility

The financing policy of a firm should be sustainable and feasible in the

long run. Most firms want to maintain the sustainability of their
financing policy over a long period of time. The sustainable growth
model helps to analyze the sustainability and the feasibility of the
long-term financial plans in achieving growth. This model is based on
the assumption that the firm uses the internal financing and debt,
consistent with the target debt-equity ratio and payout ratio and does
not issue shares during the planning horizon.

Sustainable growth = ROE x (1 - payout)

The sustainable growth model indicates the growth rate that the firm
should target. Any other growth rate will not be consistent with the
financial policies set by the management. If the firm intends to achieve
a different growth rate than that implied by the sustainable growth
model, it will have to change its financial policy, either the debt-equity
ratio, or the payout ratio or both. In fact, the model also indicates the
trade-offs between the financing and operating policies. The firm
should also examine the impact of alternative financial policy on the
value of the firm.

8. Degree of Control

In a company, it is the directors who are so called elected

representatives of equity shareholders. These members have got
maximum voting rights in a concern as compared to the preference
shareholders and debenture holders. Preference shareholders have
reasonably less voting rights while debenture holders have no voting
rights. If the company’s management policies are such that they want
to retain their voting rights in their hands, the capital structure
consists of debenture holders and loans rather than equity shares.
9. Choice of Investors

The company’s policy generally is to have different categories of

investors for securities. Therefore, a capital structure should give
enough choice to all kind of investors to invest. Bold and adventurous
investors generally go for equity shares and loans and debentures are
generally raised keeping into mind conscious investors.

10. Capital Market Condition

In the lifetime of the company, the market price of the shares has got
an important influence. During the depression period, the company’s
capital structure generally consists of debentures and loans, while in
period of boons and inflation, the company’s capital should consist of
share capital generally equity shares with high premium. The internal
conditions of a company may also dictate the marketability of
securities. For example, a highly leveraged company may find it
difficult to raise additional debt. Similarly, when restrictive covenants
in existing debt debt-agreements preclude payment of dividends on
equity shares, convertible debt may be the only source to raise
additional funds. A small company may find difficulty in issuing any
security in the market merely because of its small size. The heavy
indebtedness, low payout, small size, low profitability, high degree of
competition etc. cause low rating of the company which would make it
difficult for the company to raise external finance at favorable terms.

11. Period of Financing

When company wants to raise finance for short period, it goes for
loans from banks and other institutions; while for long period it goes
for issue of shares and debentures.

12. Issue Costs

Issue or flotation costs are incurred when the funds are externally
raised. Generally, the cost of floating a debt is less than the cost of
floating an equity issue. This may encourage companies to use debt
than issue equity shares. Retained earnings do not involve floatation
costs. The source of debt also influences the issue costs with fixed
costs being much higher for issue of commercial paper and public debt
(debenture) than the private debt. Debt instruments must be used
when large amounts of funds are needed. Issue costs as a percentage
of funds raised will decline with larger amounts of funds. A large issue
of securities can however curtail a company’s financial flexibility. The
company should employ only that much of funds, which it can employ
profitably.
13. Stability of Sales

An established business which has a growing market and high sales

turnover, the company is in position to meet fixed commitments.
Interest on debentures has to be paid regardless of profit. Therefore,
when sales are high, thereby the profits are high and company is in
better position to meet such fixed commitments like interest on
debentures and dividends on preference shares. If company is having
unstable sales, then the company is not in position to meet fixed
obligations. So, equity capital proves to be safe in such cases.

14. Legal Requirements

The Government has also issued certain guidelines for the issue of
shares and debentures. The legal restrictions are very significant as
these lay down a framework within which capital structure decision has
to be made. For example, the controller of capital issues, now SEBI
grants his consent for capital issue when (a) debt equity ratio does not
exceed 2:1 (for capital intensive projects a higher debt equity ratio
may be allowed), (b) the ratio of preference capital to equity does not
exceed 1:3 and (c) promoters hold at least 25% of the capital.

15. Consultation with Investment Bankers and Lenders

Another useful approach in deciding the proportion of various

securities in a firm’ structure is to seek the opinion of investment
analysts, institutional investors, investment bankers and lenders.
These analysts having been in the business for a considerable period
acquire expertise and have access to information regarding securities
of a large number of companies and know how the market evaluates
them. They are therefore in a better position to assess a particular
financial plan. Similarly the opinions of perspective lenders and
investors are likely to be very useful to the firm; it is they who will
ultimately provide funds to the firm. Therefore, the type of securities
which they will prefer to buy is very significant information for the
financial manager and helps him in taking a decision regarding the
form of the securities to be issued.

16. Size of the company

Small size business firm’s capital structure generally consists of loans

from banks and retained profits. While on the other hand, big
companies having goodwill, stability and an established profit can
easily go for issuance of shares and debentures as well as loans and
borrowings from financial institutions. The bigger the size, the wider is
total capitalization.